Is the Political Economy of Financial Regulation Really Fundamentally Different?

A common theme in many of our posts is that there is something different about the political economy of financial regulation -- particularly systemic risk regulation.  Erik argues this is because of the presence of government subsidies in this domain, which place costs on the most diffuse group possible (taxpayers) and are hard to value ex ante.  Saule's thoughts are similarly premised on the notion that there is no natural public interest group for systemic risk regulation.  Kim's work suggests that financial regulation may face distinctive political dynamics because of the  difficulty that ordinary individuals have in meaningfully engaging with the complexities  of the underlying issues.  Brett suggests that part of the problem is that the public only pays attention to systemic risk immediately after a crisis, but by the time that the rules are (or should be) implemented public attention is focused elsewhere, allowing industry to dominate regulatory proceedings.  And Christie worries that the prevalence and logic of flexible regulation in financial regulation makes it susceptible to industry influence.

I think there is much truth and wisdom in these characterizations of the process of financial regulation, and systemic risk regulation in particular.  At the same time, I wonder exactly how distinctive financial regulation is on these fronts.   Erik is clearly right that few industries enjoy government guarantees in the same way as financial firms.  But it seems to me that there are many regulatory domains in which costs are externalized on to a group that is even more diffuse than taxpayers.  The most obvious example is environmental regulation, where those who bear the cost of excessive risk are citizens, non-citizens, taxpayers and non-taxpayers.  And the costs of environmental harms are equally, if not more, indeterminate than then costs of financial guarantees.

Now, it is surely true that there are numerous public interest groups in the environmental domain relative to financial regulation, so this may suggest that the key difference is actually the complexities of financial regulation, relative to environmental regulation.  But the details of environmental regulation are themselves immensely complex: is it any more complex/ boring/ difficult to decide how many parts per a million of some obscure chemical firms should be allowed to release in the atmosphere than it is to decide how much regulatory capital financial firms should maintain?  Perhaps the difference does not involve the complexity of the underlying regulatory issues as much as it involves the salience of the broad regulatory topic.   It's always appealing to donate to environmental public interest groups who want to save pandas and polar bears.  Maybe there is no analogous pitch that can be made to support public interest groups focused on systemic risk regulation?  

This may be.  But it's worth pointing out that one of the core motivations behind the Tea Party movement has been anti-bailout sentiment.  Now the Tea Party is certainly not engaging in the regulatory process in the same way as public interest groups typically do.  But whether this will continue to be so in the future is less clear to me.  In any event, there are clearly numerous regulatory domains in which there are just as few public interest groups as in financial regulation (limited to systemic risk issues): consider regulation with respect to telecommunications or food safety.  

Nor does it seem to me that financial regulation is fundamentally different from other forms of regulation with respect to the prevalence of flexible regulation as a necessary or dominant strategy.  Indeed,  flexible regulation is at the heart of the "new governance" literature.  And only a very small percentage of this writing (with Christie's excellent work being a notable example) is focused on financial regulation.  

Similar responses can be made to the notion that financial regulation is inherently cyclical in the attention it captures from the public.  Mining accidents create immediate demands for enhanced regulation, but the public soon forgets about the issue and it drops out of the news cycle.  This is also true of environmental accidents such as the BP oil spill -- when was the last time any of us saw (much less read) news coverage on regulations governing deep water drilling?  And while it may be true that the worst time to implement stricter regulations is in the immediate aftermath of a crisis (when political will to do so still exists), rule-making is an inherently slow process meaning that there will always be a large gap of time between an event that draws public scrutiny and a permanent, rule-based, regulatory response.

 In the end, I DO think that the political economy of financial regulation is different in many ways.  This results from the combination and particular instantiations of all of the factors that have been identified in this forum.  At the same time, though, each of these individual issues also arises in other regulatory contexts.  As such, I think we have much to learn from work on combatting regulatory failure that is not specific to financial regulation.  Two of my favorite recent entries to this literature are Rachel Barkow's Insulating Agencies: Avoiding Capture Through Institutional Design and Wendy Wagner's Administrative Law, Filter Failure, and Information Capture.   Notably, much of what these articles discuss overlaps with the themes we have been hitting on in the course of this forum.

 

Comments

[Kim Krawiec]

I'm with you, Dan. It's not that financial institution regulation is unique and certainly is not the case that we can't learn from a study of the regulation of other subject matters. It's just -- to my mind -- that some of the systemic risk provisions of D-F have a potentially different political economy than some of the other D-F provisions, such as consumer protection (which, by definition, consumers can at least see how the subject relates to them) or even the derivatives clearing and trading provisions (which arguably could pose barriers to entry issues).

Though now that I say that, perhaps it is the case that each issue is both similar and different in important ways -- from my outsider's perspective, the compensation debates seem to be their own animal as well, though I haven't followed them as closely as others have. But given that we don't know the end result of most of D-F yet, that conclusion certainly could be premature.

In any event, thanks for the posts and the links.

[Cristie Ford]

Hi Dan,

Thanks for this wonderfully thoughtful dissection of the problem. I agree with you and Kim that financial regulation doesn't seem to be really different from other areas of regulation along any of the important parameters - complexity, the ability to externalize costs, salience and the cyclicality of that salience. In fact I often wonder whether new governance scholars working in other subject matter areas might benefit from paying more attention to financial regulation and its recent problems than they do. I'm not so sure it can't happen there.

Taking a flier here, is it possible that financial regulation is different because in that context it is easier to argue that we can have our cake and eat it too? Financial innovation and regulatory scholars sometimes speak as though the pros and cons of regulation, and innovation, are the same in kind. Leaving aside wealth transfers through rent-seeking, which few would defend, academic economists see their goal as maximizing the efficiency of capital use. They may determine that zero regulation maximizes it or that lots of regulation maximizes it, but the underlying conviction continues to be that more efficient use of capital lifts all boats. By contrast, the pros and cons of environmental regulation are different in kind. We are weighing polar bear habitat, climate change, etc against decreased power generation, smaller profits, etc. Okay, I see the analogical leaps in my argument here but I'd still argue that, because the relative values placed on polar bears vs. cheap energy are largely subjective, it is tougher to come to an agreement on what level of regulation maximizes welfare. It is also necessary to confront hard choices. In finance, there is always the seductive possibility of getting to have your cake and eat it too. What if we deregulated, and we all got richer?

[Brett McDonnell]

I largely agree that financial regulation is not fundamentally different. Indeed, most of the ideas that all of us have been discussing here have been drawn from more general literature that is not specific to finance. But in addition to some of the differences in detail that Dan, Kim, and Cristie discuss above, I want to mention one thing that has not yet received enough eattention in this forum (including from me).

The growth of financial markets over the last few decades is closely tied to the growth in economic inequality over that time. The growth in inequality has many causes, but financial markets are a big part. The super-rich are that way often because of investments in the financial markets. Top public company officers have gotten rich through equity compensation. Investment bankers, accountants, corporate lawyers, and yes, law professors, have also eaten from this gravy train. The fight to control the growth of financial markets is thus tied to the fight to control inequality in a way that is not at all true for environmental regulation. Even our rather antiseptic talk about systemic risk is linked to this. I have been shocked that for most of the last two years until the last couple of weeks, we have been talking much more about deficits than jobs. That is possible only because of who exercises power in this country. Think too about the anger that showed through in the comment letters from ordinary people that Kim discusses.

Hmm, in my papers I've been a rather centrist Obamaite. My last post veered towards a much more minimalist libertarian position. Here I'm sounding like a radical populist. I seem to be becoming unhinged on (by?) this topic.